Not all inflation is the same

Economics 101 will introduce everyone to the concept of inflation and an explanation that inflation occurs when the prices of goods and services keep rising. We may have also come across the very simplified definition of inflation being: “too much money chasing too few goods”, and I doubt that anyone who has come across that particular definition ever forgets it.

In a subsequent (and slightly more advanced) class, the concept of inflation gives birth to identical twins that are named: ‘Demand Pull Inflation’ and ‘Cost Push Inflation’. For some reason, Demand Pull was the more favoured of the twins and Cost Push was treated as a step child and almost altogether forgotten and relegated to the background.

I’d like to dedicate this article to the memory of that lost twin, tell the story from his perspective and show how forgetting him has led many-a-central-banker astray to the detriment of entire economies.

So who is Mr. Cost-Push Inflation? In order to prevent us from having to abandon him once more, I’ll keep it very short and simple: The rise in production costs gives rise to cost-push inflation.

I know I said I’d dedicate this to Mr. Cost Push, but just so we can see the difference, let me quickly run through the distilled breakdown of inflation.

Inflation: constant rise in overall process of goods and services

Demand pull inflation: when the rise in goods and services comes from an increase in money supply.

Cost push inflation: when the rise in goods and services comes from an increase in cost of production.

So while in general, inflation is the persistent increase in the cost of goods and services, cost push inflation in particular is the result of an increase in the cost of production inputs. However, demand pull occurs when the increase in prices results from a decrease in supply and/or an increase in demand.

Despite the fact that we can and will frequently refer to both as “inflation,” it is important to make this distinction because each requires a different strategy for management.

In an economy being adversely affected (yes I have to add “adversely” because sometimes, inflation, when moderate and contained, can have a net positive effect) by cost push inflation, the remedy, as I am sure you have already figured out, will be to bring costs down. If you make the grave error of misidentifying the twins and you apply the remedy of demand pull to cost push, you will inadvertently be exacerbating the problem and rapidly spinning your wheels down a rabbit hole.

Cost push inflation will have a couple of components but to make the illustration easier and to localise it to our experience, let’s break it the “cost of production” into three particular costs:

1. FX rate

2. Interest rate

3. Wages and other costs

If you therefore effect any policy that ends up increasing any of these cost components in a cost push inflationary environment, you will be, as we say, “pouring petrol on a fire”.

Nigeria is experiencing cost push inflation, although it is being mistaken for its well-known sibling.

What can be done to combat cost-push inflation? The apparent approach will be to lower costs if cost push is brought on by a steady rise in production costs. And if we concur that interest rates and foreign exchange rates are currently Nigeria’s two main cost factors, then one or both of them must decrease in order to address cost-push inflation.

Then, it becomes very difficult to understand why, over the past few years, we have been boosting costs by raising interest rates and allowing the currency to depreciate in order to combat cost push inflation.

In the past 18 months, in our current cost-push inflationary climate, we have increased input costs of the two major input components – foreign exchange rates and interest rates – by up to 100 percent and 40 percent, respectively, all in the ludicrous pursuit of lowering prices.

Now, if only the crazy had ended there, perhaps, just perhaps, we might explain away the irrationality of our behaviour as mistaken identity between twins, on the premise that the monetary policy authority’s activities were unintentionally targeted at demand pull inflation rather than cost push.

In the case of demand pull inflation, when you raise interest rates in order to curb (demand pull) inflation, it is supposed to achieve two things simultaneously:

Higher interest rates incentivise the citizens to save and disincentivise consumers from borrowing.

The interest rate transmission mechanism must be nearly flawless for this dual purpose to work. You need a supportive environment for consumer credit, such as one where people can borrow money right away, as is usual in a culture where credit cards are extensively used and one where saving rates are immediately impacted by monetary policy rate (MPR) changes.

Needless to say, neither exists in Nigeria, where our society is not based on consumer credit, at least not the kind that is impacted by monetary policy rates; therefore rising interest rates have no impact on the average consumer for whom there is no transmission mechanism. I don’t consider the loan shark-type-lending as consumer credit as a vehicle for interest rate transmission mechanism.

So, even when interest rates are hiked, a family with a set monthly income would not have reduced access to cash flow without a credit programme. We will simply raise the price of goods and services, thereby simultaneously raising people’s costs of living and lowering their standard of living, hence increasing consumer pain.

It is difficult to comprehend why the CBN keeps raising interest rates given that:

1. The monetary policy rate and government borrowing and saving rates have no real correlation.

2. Consumer credit is either non-existent or rates there are also uncorrelated to the MPR.

Read also: Rising inflation, FX pain bite consumer firms as unpaid bills rise by 34%

This graph with five years data from 2018 shows the stark dislocation between government borrowing rate (treasury bills), inflation and the MPR.

If what we have cultivated via misplaced policy priorities is a bad case of cost push inflation being treated as demand pull, or perhaps, and it is quite possible, we have the twins coexisting in our economy and we may indeed be experiencing both demand pull inflation (from the excess money creation by the CBN and reckless spending over the last 5-8 years) as well as cost push inflation, with an all new board of governors within the CBN, an IMF meeting this week and a terribly flailed citizenry, a radical difference in thinking and approach to analysing and solving our inflation issue is needed.

Akaraiwe is a financial adviser based in Lagos